Mini Case on Pay-back Period

The pay-back period is the least accurate method of evaluating a capital expenditure. Why is it used so often?

Mini Case: Your organization is going to purchase (lease) a new copy machine. You have scheduled presentations from sales representatives from four competing companies. It is your job to compile a list of questions to ask them. What questions should be on this list? Is this an example of an independent or mutually exclusive decision? When it comes down to the final decision, which capital budgeting technique will you select to evaluate the four competing options?

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The pay-back period is the least accurate method of evaluating a capital expenditure. Why is it used so often?

Under the Payback Method, we compute the amount of time required for an investment to generate cash inflows sufficient to recover its initial cost. Based on this method, an investment is acceptable if its calculated payback period is less than some pre specified number of years. This method is least accurate because it suffers from some important shortcomings:

(1) The payback period is calculated simply by adding up the future cash flows. There is no discounting involved, so the time value of money is completely ignored. (2) The payback rule also fails to consider risk differences. The payback would be calculated the same way for both very risky and very safe investments. Finally, the payback method completely ignores all cash flows beyond the payback period. Moreover there is no rational for the cut off period. There is also bias for short term projects.

But this method is used so often because:
1) It is easiest to use as it is very simple to calculate and easy to comprehend
2) Thus it's cost effective
3) It tells the short-term effects of the project
4) It also gives an indication of the risk of the project. Higher payback period indicates greater risk of the project.
5) It also tells about the liquidity of the project.

Mini Case: Your organization is going to purchase (lease) a new copy machine. You have scheduled presentations from sales representatives from four competing companies. It is your job to compile a list of questions to ask them. What questions should be on this list? Is this an example of an independent or mutually exclusive decision? When it comes down to the final decision, which capital budgeting technique will you select to evaluate the four competing options?

This is an issue of investment decision. The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Thus capital budgeting has following characteristics:

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Solution Summary

1430 words explain why the pay-back period is so used despite being the least accurate method of gauging capital expenditure.